A short sale or a foreclosure can come with a twist: it can have severe tax consequences which only hit you after the fact. By relinquishing a property with negative equity, you incur what is called phantom income from cancellation of indebtedness unless…
… unless you are still liable for the remainder of the debt. This phantom income is then taxable as capital gains. Surprise!
Fortunately, there is more than one legal way out but you must know about it. Real Estate investors also have plan well in advance if they want to avoid trouble.
How you proceed depends on your individual circumstances. A lot hinges on whether you want to relinquish an investment property or your homestead (your primary residence).
There at least three strategies:
- use the Mortgage Forgiveness Debt Relief Act of 2007 as your first line of defense against taxes on forgiven debt
- file Form 982 with the IRS to ask for tax forgiveness
- trade up through a 1031 tax-deferred exchange and wait this market out
Homeowner’s First Line Of Defense Against Taxes On Forgiven Debt
If you relinquish your primary residence, your first line of defense is the Mortgage Forgiveness Debt Relief Act of 2007. It protects you from taxes on debt forgiveness resulting from defaults from 2007 through 2012 if the loans were “qualified principal residence indebtedness”. This means that you only qualilfy if your original mortgage debt or subsequent loans secured by your equity were taken to buy, build, repair, rebuild, or substantially improve your main home (loans qualify only up to the amount of the old mortgage principal just before the refinancing). This also applies to farm debt.
You can read more about this on the IRS website: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation.
File Form 982 With The IRS To Ask For Tax Forgiveness
If the property in question does not qualify you for the Mortgage Forgiveness Debt Relief Act, do not despair. Many homeowners financial situation at the time of debt forgiveness qualifies them for tax forgiveness on the grounds of temporary insolvency. If you want to pursue this opportunity, file form 982 with the IRS. You will only be liable for tax on the amount of your assets which exceeded your outstanding liability on the last day before cancellation of debt.
Trade Up Through a 1031 Tax-Deferred Exchange (And Wait This Market Out)
Real estate investors will most likely fare best if they trade up the property they want to relinquish for a better property through a 1031 tax-deferred exchange, then wait this market out.
For example, you may own a property which could fetch half a million dollars on the market and also carries a debt of half a million dollars, but the basis is $380,000. If you were to give the lender a deed in lieu of foreclosure or the lender decides to foreclose, you would face a tax liability on the difference between the sales price and the adjusted basis. Rather than incurring the tax liability, you can exchange the property for a property which is valued at a higher price. If you were to purchase a property valued at $600.000 by using some other collateral as a down payment and place a debt of $500.000 on the replacement property, such a transaction could be eligible as a tax-deferred exchange. By putting down your other assets as collateral you avoid a foreclosure on the property you relinquish and avoid incurring a tax liability which might have forced you to liquidate your other assets to pay off the IRS. And if you make a smart pick you can end up with a positive cashflow in your pocket from the rental income of your new property.
In a possible scenario, you convey the property you want to relinquish to a Qualified Intermediary before foreclosure (this can incur taxes in some jurisdictions). The lender then forecloses on the property, now owned by the Qualified Intermediary, or accepts the deed in lieu of foreclosure. By showing your lender how the new, more valuable property, secured with additional collateral, will pay for itself you should be able to convince your lender to co-operate. So long as your rental income from the new property will allow you to service the debt more easily, the lender wins too. However, you should consult with experienced real estate and tax professionals and think real hard about which property to pick.
Given that the market may not recover for another few years, this decision is not do be taken lightly. In your selection of a new investment property to escape an impending foreclosure through a 1031 tax-deferred exchange, your new property’s ability to produce a positive cashflow should override any considerations of its potential for capital gains so that you can wait the market out.